Quick Ratio is a metric used to determine the short-term liquidity of a company. By focusing only the most liquid assets, it allows business owners and business leaders to get more granular than Current Ratio. By ignoring assets that will not be quickly turned into cash (and other prepaid expenses), Quick Ratio is a more precise view of the short-term liquidity of your company.
What Is Quick Ratio?
Quick Ratio takes only a company’s most liquid assets and applies them against the current liabilities. Inventory and prepaid expenses are not used in the Quick Ratio calculation. The time to sell inventory is not always consistent, so you might not be able to count on converting it to cash in the short-term. Prepaid expenses (such as rent, software) are an asset, but Quick Ratio excludes them, because they usually cannot be quickly converted into cash.
Quick Ratio Calculation
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
Cash, Marketable Securities, and Accounts Receivable are the current quick assets of the Quick Ratio formula. Marketable Securities refers to short-term investments that can quickly be converted to cash. As stated in the previous paragraph, the Quick Ratio formula differs from Current Ratio, because it excludes inventory and prepaid expenses from the current assets.
Current Liabilities includes accounts payable, accrued expenses, short-term loans, and current portion of long-term debt.
Simple Example of Quick Ratio
Tina has an ecommerce business selling jewelry she purchases from China. She typically purchases the jewelry inventory twice a year to take advantage of bulk discounts.
Tina’s Ecommerce Business
Cash: $50,000
Accounts Receivable: $45,000
Marketable Securities: $0
Inventory: $25,000
Prepaid Expenses: $10,000
Current Liabilities: $100,000
Quick Ratio = (Cash + Accounts Receivable + Marketable Securities) / Current Liabilities
($50,000 + $45,000 + $0) / $100,000
Tina’s Quick Ratio = 1.05
Tina’s ecommerce business on a high level looks healthy. Her Quick Ratio of 1.05 means she has $1.05 in current quick assets to cover every $1 of current liabilities. If an unforeseen event occurred, such as a slowdown in jewelry sales due to changing customer taste, Tina has enough accessible short-term liquidity to pay her current liabilities.
What Is A Good Quick Ratio?
In general, you want a Quick Ratio above 1. This is the minimum to cover your current liabilities with easily cash-accessible assets. There are business reasons why your Quick Ratio could be below 1 and still represent a healthy business. For example, your Quick Ratio will change during the course of the year. If you have $100,000 of cash on hand one month then purchase $75,000 worth of inventory the following month, you would expect to see a negative swing of your Quick Ratio. This does not mean your business is suddenly bad.
Charting your Quick Ratio monthly is a smart way to learn your business health trend. For example, you might see your Quick Ratio hovering above 2 compared to the previous year when it was always below 1.5, which could indicate your inventory is not selling (turning into cash or accounts receivable). This is a good example of how charting a simple metric like Quick Ratio can alert you that it’s time to start asking questions about why your inventory is not moving as expected.
Who Should Use Quick Ratio?
While anyone can use Quick Ratio, it is usually best for businesses who hold inventory. Newer businesses who hold inventory present an even better use case. It is not always easy to predict what will happen with purchased inventory. It is even more difficult for newer businesses to understand the trends of their inventory. By using Quick Ratio, you eliminate inventory from the calculation and give yourself a conservative starting point to understanding your current assets vs current liabilities.
Quick Ratio Summary
Quick Ratio is an alternative to Current Ratio to evaluate the short-term financial health of your business. It eliminates inventory and prepaid expenses from your current assets to give you a better view of how well you can cover the current liabilities. Companies who hold inventory are a great candidate to use Quick Ratio as a basic metric to chart monthly and gain a better understanding of their business health.